What is Credit Default Swap (CDS)?

A Credit Default Swap or CDS is a financial contract or derivative that allows one party (the protection buyer) to transfer the credit risk of an underlying asset, typically a bond or a loan, to another party (the protection seller) in exchange for regular premium payments.

What is CDS?

Credit default swaps (CDS) are financial derivatives associated with the credit risk of bonds issued by a company or a government and are similar to an insurance contract. The main purpose of CDS is to help manage the credit exposure of fixed-income investments between two or more investors. A CDS allows investors to hedge against unexpected market volatility and other risk factors.

Two parties enter the CDS contracts where the seller sets a periodic premium that the buyer pays. In return, in case of non-payment, the seller will compensate the buyer for his losses.

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Content

• CDS Analogy – Bank Loan Portfolios
• Background of CDS
• How CDS Works?
• Advantages of CDS
• Disadvantages of CDS
• Common CDS Terminologies
• Key Takeaways

CDS Analogy – Bank Loan Portfolios

Suppose a bank has provided loans to various businesses. These loans are assets on the bank’s balance sheet, and the bank earns interest income from them. However, the bank is concerned about the possibility of some of these borrowers defaulting on their loans, which could lead to significant financial losses.

The bank enters into CDS agreements with other financial institutions to reduce its exposure to potential loan defaults. The bank effectively transfers some of the credit risk associated with its loans to other financial institutions. If one of the borrowers defaults on its loan, the bank receives a payout from the CDS contracts to offset its losses.

Background of CDS

Credit Default Swap was invented to provide banks with the means to transfer credit exposure, but later, it became an active portfolio management tool. The performance of CDS, like corporate bonds, is closely related to changes in credit spreads. This makes them an effective tool for hedging risk and efficiently taking credit exposure.

The CDS market, with a current valuation of approximately $3.8 trillion, according to the International Swaps and Derivatives Association (ISDA), has significantly contracted from its peak of $33 trillion in 2008. The CDS market remains relatively small compared to other financial markets, such as equities, foreign exchange, and the global bond markets. 

The global bond market’s outstanding value exceeds $120 trillion, and foreign exchange sees a substantial daily trading volume nearing $8 trillion, highlighting the relatively modest scale of the CDS market.

How CDS Works?

Here is a simplified process of how CDS works –

The fundamental steps involved in Credit Default Swap are as follows – 

1. The credit risk transfers from a protection buyer to a protection seller.
2. The protection buyer pays a premium to the protection seller. This premium is similar to an insurance premium and is paid periodically.
3. In exchange for the premium, the protection seller assumes the risk of default on an underlying asset, such as a bond or loan.
4. If a default event occurs on the underlying asset, the protection buyer has the right to receive compensation from the protection seller. This compensation is determined based on the face value of the underlying asset.

Advantages of CDS

• CDS provides liquidity and allows portfolio diversification.
• It allows investors to buy or sell protection on various credit risks quickly.
• CDS makes managing and trading credit exposure easier.
• Investors can use CDS to diversify their portfolios by gaining exposure to different credit risks without directly owning the underlying assets.
• CDS can be valuable tools for banks and financial institutions to hedge against credit risk in their loan portfolios, reducing potential losses from defaults.
• CDS spreads can provide useful information about market perceptions of credit risk, helping assess and price credit risk.

Disadvantages of CDS

• Credit Default Swap contracts are bilateral agreements, which means each party relies on the other to fulfil their obligations. If one party defaults, it can lead to significant losses for the other.
• CDS contracts can be highly complex, with terms and conditions tough to understand, leading to misunderstandings and disputes.
• CDS can be used for speculative purposes. Speculative trading can increase market volatility.
• CDS markets are often over-the-counter (OTC), which means they are less transparent than exchange-traded markets, making it difficult to accurately assess market conditions and pricing.
• The use of CDS has raised regulatory concerns, as excessive risk-taking and lack of oversight contributed to past financial crises.

Common CDS Terminologies & Events

Related Read – Difference Between Central Bank and Commercial Bank

Key Takeaways

CDS Basics

• CDS is a contract between two parties to protect against losses from a borrower’s default.
• It is based on the debt of a third party known as the reference entity, typically a senior unsecured bond.

Parties Involved: 

• The credit protection buyer is short the reference entity’s credit.
• The credit protection seller is long the reference entity’s credit.

Credit Events: CDS pays off upon credit events like bankruptcy, failure to pay, and involuntary restructuring.

Settlement Methods: Settlement can be through cash payment based on the cheapest-to-deliver obligation or physical delivery of the reference obligation. Cash settlement uses auction results to determine the payout.

CDS Varieties: CDS can be on a single entity or as indexes with multiple entities. 

Fixed Payments: Fixed payments from the CDS buyer to the seller are typically set at an annual rate (e.g., 1% for investment-grade debt and 5% for high-yield debt).

Monetization: Parties can monetize gains or losses by entering offsetting positions matching the original CDS terms.

In a Nutshell

If you want to buy credit default swaps, be aware they are traded over the counter. The swap value can fluctuate depending on the probability of a credit event. If required, investors can sell their interest to another individual or entity and make an exit. Remember that credit default swap accounting requires in-depth market knowledge.